How Interest Works

Do you have debt? Welcome to the club! Almost everyone in America has debt of some kind. Each piece of debt has a built-in interest rate associated with it. It seems that there are a lot of misconceptions in the world about how interest and debt payments actually work. That’s what I want to focus on today. I want you to understand how important that number is and how it impacts your debt payoff.

This can be confusing, but I will have an example at the end to help explain everything.

When you take out a loan to buy something such as a car or house, you receive an amortization schedule breaking down how each payment will apply to principal and interest. Principal is the debt itself, and interest is based off the rate that you qualified for. Interest is calculated monthly based on the amount of principal that is left. This is something that I don’t think is very well explained by those people selling you the loans.

I hear this phrase all the time, “You pay most of the interest in beginning so it isn’t worth paying extra.” Yes. That is true. But it is only true because the principal balance is larger at the beginning of your loan. Don’t let someone convince you not to pay down debt early because of that argument.

I have one more item to mention before the example. Don’t buy things based on the monthly payment. It happens all the time. People will buy a car as long as the payment is under $400 or whatever number works in their mind. Car salesmen know this, which is why they have started spreading loans over 60 and even 72 months. That’s 5 or 6 years! The average auto loan used to be 3 years. If you have ever sat in the sales room finalizing your purchase, you remember them saying that the tire warranty is only an extra $18/month. Focus on the actual purchase price of items and it will save you a lot of money long term.

Example: Congrats! You just bought a house. The final price was $300,000 and you managed to put 20% down so there is no PMI (Private Mortgage Insurance). The loan amount is $240,000 and you got an interest rate of 3.5%. The monthly payment is $1,427.71. You pay for insurance and property taxes in that payment totaling $350 each month.

The first payment is calculated by taking the total principal of $240,000 times 1/12 of the interest rate (3.5/12). Once interest is calculated, add in your insurance/property taxes. Then whatever is leftover is applied to principal. Let’s break down the first payment.

Interest = $700 ($240,000 x (3.5/12))

Insurance/Property Tax = $350

Principal = $377.71

Total = $1,427.71

You only pay down $377.71 of debt on that first payment! That amount is subtracted to calculate the next payment. Let’s break down the second payment.

Interest = $698.90 ($239,622.29 x 3.5/12)

Insurance/Property Tax = $350

Principal = $378.81

Total = $1,427.71

You get the point. But let’s say you wanted to pay down your house early. What would the effect be if you paid an extra $1,000 with your first payment? That would be directly towards principal. Let’s break down the second payment in this circumstance.

Interest = $695.98 ($238,622.29 x 3.5/12)

Insurance/Property Tax = $350

Principal = $381.73

Total = $1,427.71

This doesn’t seem like a big deal, but you just saved about 3 months of payments! That is $2100 in interest. Even if you were just able to pay $400, that would still be the equivalent of a double mortgage payment.

I hope this helps you understand how debt payments work. Paying off debt early does save money. Don’t let someone convince you to keep a loan around because the interest is deductible or that you’re paying extra interest in the beginning. That guy in the cubicle next to you doesn’t always know what he is talking about.

Mike Zeiter, CPA/PFS